Conflict of Interest at the Federal Reserve  Operation Twist is Utter Failure

The Fed officially began buying the long end of the Treasury curve on October 3, purchasing about $12 billion of bonds and notes through today’s trade to kick off their newest monetary experiment termed “Operation Twist,” or as the Fed more eloquently calls it, the Maturity Extension Program & Reinvestment Policy. In these last six trading sessions, the Fed has lost about $450 million in principal value on its purchases while institutions on the other end of the trade have cashed-in big time.

The Fed is scheduled to purchase $400 billion in longer-term Treasuries through June 2012 with over $40 billion of those purchases in October alone. Heavy institutional buying pushed longer-term Treasury prices to surge more than 25% in the two months leading up to Operation Twist, and the Fed has been buying the top, losing money on each of its last five purchases. Should the Fed anticipate further declines in bond prices, it’s plausible they may reconsider their latest action to avoid heavy losses, revealing a conflict of interest.

The most often cited conflict of interest at the Fed is in relation to its aversion to raise interest rates in an effort to preserve the value of its bond portfolio. While this is certainly an issue and is magnified by the latest Fed action, there also exists a similar conflict of interest if the recent sharp decline in longer-term Treasury prices continues its trend downward from its peak on October 4. This is the market’s way of raising interest rates, and as they rise, the value of the Fed’s portfolio falls.

Regarding the failure of Operation Twist, look no further than the policy’s stated goal. The Fed states that the Maturity Extension Program & Reinvestment Policy will “put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities.” If this is what’s supposed to happen, then why have rates gone from 1.72% to 2.17% on the ten-year and from 2.70% to 3.11% on the thirty-year since the Fed first began buying longer-term Treasuries? Rates have done nothing but rise since the Fed entered the market last week as the institutions began selling their holdings. Those institutions that got in early, made a 25% return plus two coupon payments in just two months. For Treasuries, that’s unbelievable! The largest, most-liquid and “risk-free” market should not be producing those kinds of returns in two months.

Here’s the dilemma facing the Fed: Institutions, both foreign and domestic, have run-up longer-term Treasury prices enormously over the last two months beginning in August and ending last Tuesday. They’ve since been selling, pushing prices down about 7% in the last week while the Fed buys into them offloading their positions. Given that Treasuries have appreciated so considerably in such a short period of time and the fact that the run-up began at an extremely elevated price, one has to assume it will continue to fall despite the massive presence of the Fed buying the whole way down. So the Fed has a decision to make. Should they continue buying into a falling market that has been heavily run-up in the short-term and risk significant portfolio losses in an attempt to lower interest rates as their policy goal states, or should they cut bait and bail on the $400 billion in purchases so as to avoid portfolio losses? Surely, they’ll continue to buy, but it’d be nice if they could acknowledge they’ve been gamed. Subsidizing trading gains for institutions may be acceptable in the minds of the FOMC, but it is heresy to legitimate financial market participants. Swiftly rising rates when the Fed explicitly states their actions will cause them to fall is simply a slap-in-the-face.